Despite this year’s LIBOR scandal, regulators risk taking too relaxed a view of standards of governance in the financial index business, says EDHEC-Risk, the financial research centre of EDHEC business school.
EDHEC says it's not surprising that regulators have so far focused largely on interest rate and oil price benchmarks in their investigations into the manipulation of key indices.
“Outrage at [the] price‐rigging of indicators that are used as benchmarks for contracts [worth] hundreds of trillions of dollars is perfectly understandable,” say EDHEC-Risk’s directors, Noël Amenc and Frédéric Ducoulombier, in a response to the European Commission’s recent consultation document on the regulation of indices.
EDHEC-Risk’s reply to the consultation has just been published on the Commission’s website, together with letters from 74 financial institutions, public bodies and other interested parties.
But an observation made by the Commission in its consultation document—that other financial indices, such as equity benchmarks, are “straightforward” —is too benign a view, say Amenc and Ducoulombier, who go on in their 17-page submission to point out the many potential conflicts of interest involved in the index business.
Changes in index constituents and constituent weightings can have a major price impact on the stocks or bonds involved, say EDHEC’s authors. And the less systematic and transparent the index methodology, the more difficult it is to anticipate index changes and the higher the risk of insider trading on the basis of information about such index events.
When the index provider also belongs to an entity that trades for its own account or manages portfolios, the risk of insider trading is even higher, says EDHEC-Risk.
Another conflict of interest may arise between index provision and the provision of stock listing services, argue Amenc and Ducoulombier, particularly when one of the attractions of listing in a particular market may be inclusion of a company’s shares in a widely followed index.
“Such conflicts of interests are present in groups that combine index provision with investment banking activities as well as in groups that combine index provision with listing and trading activities,” say the two authors, citing as an example of potential conflict the May 2011 initial public offering (IPO) of Glencore shares on the London Stock Exchange (LSE).
As the result of what EDHEC-Risk calls “an opportune October 2010 change to the [index’s] ground rules”, shares locked up for up to a year post‐IPO were assumed to be part of Glencore’s free float for the purposes of inclusion in the FTSE 100 index. Normally, as a non-UK company, Glencore’s free float of 12 percent at listing would have fallen well short of the minimum 50 percent threshold required by FTSE.
EDHEC-Risk notes that when welcoming Glencore to the LSE last May, the exchange’s CEO specifically mentioned that the company’s London listing would “give it entry to one of the world’s most tracked and traded indices, the FTSE 100.”
At the time of Glencore’s listing the LSE owned 50 percent of FTSE, moving to acquire full ownership of the index provider in a £450 million deal last December.
Index providers may also alter their indices’ composition in directions which they may consider to be in the best commercial interests of the index, but which may not be in the interests of index users, say Amenc and Ducoulombier.
The authors cite NYSE Euronext’s September 2012 inclusion of Belgian chemical company Solvay’s into the exchange’s main French share index, while the company’s shares remained in NYSE Euronext’s index of Belgian blue chip companies, as an example of the non-systematic application of index rules.
EDHEC-Risk also highlights the risks of conflicts that it says are inherent in the rapidly growing market for strategy indices, which embed an investment strategy into an index of shares or bonds with the objective of providing superior performance to standard, capitalisation-weighted benchmarks.
As such strategy indices are marketed primarily on the basis of their potential returns, says EDHEC-Risk, the linkage of the index provider’s revenues to the assets under management in related funds could tempt index designers to select or weight components with a view to boosting performance.
“There are risks that hindsight biases (choosing from survivors, using restated/backfilled data, picking winners or shunning losers, etc.) [may enter] an index simulation, whether or not there was an intention to mislead,” say Amenc and Ducoulombier.
To prevent such cases of manipulation, say the EDHEC-Risk authors, it’s important that investors are able to conduct thorough examinations of indices’ track records and methodologies on the basis of verifiable historical data.
